Series of Delaware Court of Chancery Decisions Highlights Importance of Earnout Drafting

The Cases

1. Fortis Advisors v. Johnson & Johnson¹

The case arose from J&J’s acquisition of Auris Health, a start-up company that had developed two ground-breaking surgical robots, Monarch and iPlatform. Unlike Auris, J&J’s efforts to develop its surgical robot, called Verb, were struggling despite substantial expenditures. Heeding the “if you can’t beat’em, join’em” adage, J&J agreed to acquire Auris for $3.4 billion upfront and another $2.35 billion upon the achievement of two commercial and eight regulatory milestones for Auris’s robots. The merger agreement’s earnout provision was tethered to an efforts provision requiring that J&J devote commercially reasonable efforts to achieve the milestones befitting a “priority medical device.”²

Within weeks of closing, J&J initiated a competition dubbed “Project Manhattan” that pitted iPlatform against Verb to determine which project J&J would back. Although iPlatform won, the competition caused the iPlatform team to deprioritize accomplishing the earnout’s regulatory milestones. J&J ultimately determined to combine Verb and iPlatform into a single project, for which iPlatform “effectively became a parts shop for Verb.”³

The Court concluded these decisions were inconsistent with J&J’s promise to use commercially reasonable efforts befitting a “priority device.”⁴ The Court found that merging Verb and iPlatform had “diluted” iPlatform’s “system, technology and team . . . to fix another device’s problems.”⁵ The Court further determined that J&J knew that merging these two projects would delay regulatory approval, and that “J&J viewed the resulting delays as beneficial since it could avoid making the earnout payment.”⁶

The Court also found actionable fraud based on J&J’s pre-signing statement that a specific regulatory approval was a fait accompli, because J&J knew the approval faced significant risk of delay. While such statements are often inactionable due to anti-reliance provisions, J&J had agreed to a one-way anti-reliance provision favoring only Auris.

Based on these findings, the Court determined that J&J’s breaches of the efforts provision contributed to the failure of 6 of the 10 earnout milestones. The Court awarded damages by multiplying the value of the earnouts for these milestones by the probability that they would have been met had J&J complied with its efforts obligations. The Court employed a similar methodology for calculating the damages associated with the one milestone related to J&J’s fraud, awarding total damages over $1 billion.

2. Shareholder Representative Services v. Alexion Pharmaceuticals⁷

At issue was Alexion Pharmaceuticals 2018 acquisition of Syntimmune for $400 million at closing, plus $800 million in earnout payments tied to development and commercialization milestones for its flagship monoclonal antibody. In the merger agreement, Alexion agreed to use commercially reasonable efforts to reach these milestones, defined as “such efforts and resources typically used by biopharmaceutical companies similar in size and scope to [Alexion] for the development and commercialization of similar products at similar developmental stages.”⁸ As the Court explained, this was an “outward facing” efforts clause to be measured by objective indicia, rather than the buyer’s past conduct or subjective intentions. Post-closing, the monoclonal antibody’s development and commercialization faced a number of obstacles and fell behind schedule. Alexion ultimately terminated the program following Alexion’s acquisition by AstraZeneca, and the sellers sued alleging that the termination had breached Alexion’s efforts provision.

Because the efforts provision was “outward facing,” but there did not appear to be a closely comparable circumstance, the Court measured Alexion’s actions against a “hypothetical company” under a number of factors such as “efficacy” and “likelihood of regulatory approval.”⁹ Under that standard, the Court found Alexion breached the efforts provision. For example, the Court found that the hypothetical company’s response to the potential safety issue relied on by Alexion as justification for terminating the project would be to gather more data, rather than terminate development. The Court also found that Alexion’s decision to discontinue the monoclonal antibody’s development was not based solely on the merits of the drug’s prospects, but also based on a desire to achieve synergies in the merger with AstraZeneca.

The Court also found that the first milestone, triggering a $130 million earnout payment, had in fact been reached, but it requested supplemental briefing regarding the total damages.

3. Fortis Advisors v. Medtronic Minimed¹⁰

The case addressed a $100 million earnout payment under Medtronic Minimed’s acquisition of Companion Medical that would be triggered if Medtronic’s sales of two “smart insulin pens” developed by Companion exceeded certain thresholds. The merger agreement’s earnout provision stated that Medtronic’s sale and development of the products would be “in accordance with its . . . own business judgment and in its . . . sole and absolute discretion” and that Medtronic would have no liability for “any decisions or actions affecting whether or not or the extent to which the Milestone Consideration becomes payable” — provided that Medtronic would “not take any action intended for the primary purpose of frustrating the payment of Milestone Consideration.”¹¹ When the milestones were not reached, sellers alleged that Medtronic had acted with the primary purpose of frustrating their achievement through various steps, including failing to incentivize sales teams and postponing marketing efforts.

The Court dismissed the claim, concluding that the sellers did not meet their “unusually heavy burden” given the buyer-favorable contractual language.¹² The Court noted that under the efforts provision, it was not sufficient to allege that Medtronic took steps targeting the avoidance of the earnout payment — rather, sellers must plead facts indicating that the primary purpose of those steps was to avoid the earnout. Yet the complaint did not plead any evidence — even circumstantial evidence — regarding Medtronic’s motivations. Moreover, the Court distinguished between affirmative steps to defeat the earnout (which were prohibited by the “not take any action” language), and simply failing to help the product succeed.

4. Himawan v. Cephalon¹³

The case arose from Cephalon’s acquisition of Ception Therapeutics, which had begun developing an antibody called RSZ that showed promise in treating eosinophilic asthma (“EA”) and eosinophilic esophagitis (“EoE”). The parties agreed to an upfront payment of $250 million, with milestone payments of up to $200 million for approval and commercialization for RSZ’s EA use, and up to an additional $200 million for RSZ’s EoE use. The merger agreement stated that Cephalon would have “complete discretion with respect to all decisions related to the business” including the “development . . . of [RSZ],” and would have “no obligation to . . . take any action to protect, attain or maximize any [earnout] payment” — provided that Cephalon must use “commercially reasonable efforts” to achieve the milestones, defined as “the exercise of such efforts and commitment of such resources by a company with substantially the same resources and expertise as [the buyer], with due regard to the nature of efforts and cost required for the undertaking at stake.”¹⁴

After the purchase, Cephalon tried for a year and a half to obtain FDA approval for both EA and EoE use. EA showed more promising results and Cephalon notified the FDA that it would no longer be pursuing commercialization approval for EoE. Cephalon was subsequently acquired by Teva Pharmaceutical Industries. Teva obtained the EA milestones and paid the $200 million EA milestone payment, but the EoE milestones were never accomplished. The selling stockholders sued Cephalon and Teva, alleging that they failed to use commercially reasonable efforts to achieve the EoE milestones by giving up on the EoE approval and instead prioritizing the EA commercialization.

As in Alexion, the Court applied this “outward looking” efforts provision by measuring the defendant’s conduct against a hypothetical company in the same circumstances. Critically, the Court interpreted that the efforts clause limitation for “due regard” of the “efforts and costs” “means that Defendants may eschew development where the circumstances reasonably indicate, as a business decision, that they not go forward,” which “includes all the costs and risks involved, including the milestone payments and the opportunity costs.”¹⁵ In light of this interpretation, the Court was unmoved by an internal email by Defendants stating that the “EoE is now a viable indication to pursue” but that the “EoE milestone payment may be the ‘killer.’”¹⁶ Put simply, the Court concluded that the acquiror was permitted to consider the earnout in determining not to continue. The Court also noted that Defendants had moved forward with respect to EA and made that milestone payment, and declined to do so for EoE after it appeared less promising. In response to the Plaintiff’s claim that the Court’s interpretation “gives sellers little protection, since it is invoked only to disallow actions of the buyer that would be against the buyer’s self-interest,” the Court concluded it “gives the Plaintiffs all that the sellers bargained for.”¹⁷ Under this standard, Defendants had satisfied the efforts provision, and Plaintiffs’ claims failed.

Takeaways

Taken together, these cases reinforce critical points for parties negotiating or performing under transaction agreements with earnout components.

• The specific words chosen in either an earnout provision, an efforts provision, or both are immensely important.

A “Commercially Reasonable Efforts” standard can invite a broad interpretation by a court. This is amplified when, as in J&J, the contractual definition of the efforts clause makes a vague reference to an undefined “priority product,” which seems to elevate the efforts required, but not in any measurable way. By contrast, a provision that merely forbids a buyer from acting for the primary purpose of avoiding the earnout, as was at issue in Medtronic, affords the buyer substantial latitude. But within these broad divides, there are many nuances for parties to consider. Should the standard require active promotion at some set level, some “at least as favorable as X” metric, the continuation of at least the status quo, or merely an obligation not to undercut performance to avoid the earnout? Should the standard consider the buyer’s past practice and/or its own similar products, or should it be “outward facing” based on what other industry participants would do? In answering these questions, it is a useful thought exercise for a party to consider how a dispute would actually be resolved under particular formulations. This could help avoid an unanticipated scenario like the Alexion case, where the Court resorted to comparison to a hypothetical company because there was no similar circumstance to apply to an “outward facing” efforts provision.

• In making decisions impacting the milestones, the permissibility of considering the earnout payment or idiosyncratic factors depends on the particular language.

The importance of wording is sharply illustrated by these decisions’ differing conclusions on whether a buyer breached the efforts provision by considering factors other than the merits of the product. In Cephalon, by bargaining for a right to consider “the nature of efforts and cost required,” the buyer was permitted to decline to move forward if that was in its best interest in light of the earnout payment. In Medtronic, the buyer achieved a similar result by negotiating for a right to take actions so long as they were not primarily for the purpose of frustrating the earnout — even if the earnout was a meaningful factor. By contrast, in J&J the buyer had no such language, and the Court found it had failed to treat the acquired product as a “priority,” based partly on the conclusion that the buyer was seeking to avoid the earnout payment. Likewise, in the Alexion case, the Court found no language that permitted the buyer to consider idiosyncratic factors such as its desire to achieve synergies in a subsequent merger.

As in other areas of Delaware law, such as busted-deal litigation, the parties’ intentions and credibility are often at play in earnout disputes — as illustrated by the J&J and Alexion cases. For this reason, a buyer is well advised to be thoughtful about formulating and documenting the steps it will take to satisfy its efforts obligations and the reasons for any decisions to change strategy or reduce the support for the product at issue.

• Whenever earnout provisions are in-play, care should be taken to ensure that the operative contractual language matches a buyer’s intentions for the acquired assets post-closing.

The J&J decision in particular underscores the importance of alignment between a buyer’s business plans and its obligations under an earnout provision. If a buyer intends post-closing to have an acquired product compete with its incumbent product, and potentially be deemphasized as a result, it should be reluctant to commit to treating the acquired product as a “priority.” Buyers in the future might also consider identifying a specific product whose efforts they would be comfortable using as a yardstick for what efforts are required.

• Great caution should be taken any time a party wholly abandons the protections of an anti-reliance provision.

In the J&J case, J&J argued that because the merger agreement had a standard integration clause, Auris was unable to rely on extra-contractual promises of future intent. The Court repeatedly made clear that the failure of J&J to secure an anti-reliance provision was fatal, “[i]f parties fail to include unambiguous anti-reliance language, they will not be able to escape responsibility for their own fraudulent representations made outside of the agreement’s four corners.”¹⁸ Generally, a failure to secure an anti-reliance provision leaves a party significantly more susceptible to fraud claims if a merger does not go as the counterparty had hoped. Specifically as to earnout provisions, the absence of anti-reliance language leaves the buyer vulnerable to claims regarding the extent of its efforts or the likelihood of the payout, which may also be used by a court to supplement or inform what would constitute “commercially reasonable efforts.”

¹ Fortis Advisors LLC, v. Johnson & Johnson et al., 2024 WL 4048060 (Del. Ch. Sept. 4, 2024).

² Id. at *14.

³ Id. at *2, *27–28.

⁴ Id.; The Court also determined that J&J had breached its efforts obligations to meet the regulatory milestones tied to the earnout provisions by 1) opting for a more complicated regulatory clearance procedure, and 2) changing the employee incentive program in such a way that disincentivized employees to meet the regulatory milestones set forth in the Merger Agreement. Id. at *30–33.

⁵ Id. at *29.

⁶ Id. at *2.

⁷ Shareholder Representative Services LLC v. Alexion Pharmaceuticals, Inc., 2024 WL 4052343 (Del. Ch. Sep. 5, 2024).

⁸ Id. at *14.

⁹ Id. at *38–39, *43–44.

¹⁰ Fortis Advisors LLC v. Medtronic Minimed, Inc., 2024 WL 3580827 (Del. Ch. July 29, 2024).

¹¹ Id. at *2–3.

¹² Id. at *6.

¹³ Himawan v. Cephalon, Inc., 2024 WL 1885560 (Del. Ch. Apr. 30, 2024).

¹⁴ Id. at *3–4, 7.

¹⁵ Id. at *11.

¹⁶ Id. at *6.

¹⁷ Id. at *12.

¹⁸ Fortis Advisors LLC, 2024 WL 4048060 at *46 (citing Abry P’rs V, L.P. v. F & W Acq. LLC, 891 A.2d 1032, 1059 (Del. Ch. 2006)).